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Shane Pt 2: Franchisors Need Mix of Company-owned Stores

CLEVELAND, Ohio – Professor Scott Shane explains to franchisors and franchisees why businesses with highly skilled employees make poor franchises, and how franchisors without the right structure in their chains leave money on the table.

Shane, professor of entrepreneurial studies at Case Western Reserve University, venture capitalist, franchise consultant, author, and New York Times small business blogger, speaks with Blue MauMau about his book, From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company. For the benefit of franchisor executives, private equity firm leaders and even franchisees, Shane illuminates the building blocks of a franchise model and the economic drivers of strategy.

This interview is the second of a three-part series.

BMM: You say that franchising lends itself to skill sets that are easily cloned. Highly skilled jobs like doctors, lawyers, or researchers do not lend themselves to franchising, while businesses that contain easily duplicated skills, such as a fast food restaurant that needs individuals to flip fries, fits franchising. 

SS: In these sectors [doctors, lawyers, researchers], the expertise doesn't lie in the model; it lies in the human capital or what people know. A franchise business is independent of what the person delivering it actually knows. What identifies franchising is that the business can be documented and written down.

The problem with franchising attorneys or doctors, well, one of the problems, is that most of what makes somebody a good attorney or doctor is that they themselves are good at solving legal or medical problems. And so when you have somebody who's good at solving medical or legal problems, then you're not giving these individuals value in franchising. And if they're not good at solving medical or legal problems, they tend not to be a good doctor or lawyer regardless of whether you can franchise.

Franchisors can't easily write down in a manual what to do to diagnose disease, because it is way too complicated to do that. But you can write down in a manual how to make a good brownie and how to provide good customer service for delivering that. And that's a good example of something where you could franchise because it doesn't require the expertise of the person buying the franchise to be successful and you can come up with a better model and deliver it to other people.

BMM: In other words, franchising dental offices would be difficult because it requires the recruitment of highly skilled and scarce resources — dentists.

SS: Right. There is not only the problem of being dependent on a scarce resource but also a dentist does not offer dental care that can be learned and applied from a manual.

Franchising works well when pretty much anybody you give it to can apply it fairly similarly. What prospective franchisors don't want is a business where there'll be huge variation in the ability to apply the model depending on who is applying it because then the franchisor's business model isn't the source of a lot of value. 

BMM: Your book on franchising is different than others. It isn't a glossary of franchise terms or a self-help book that advocates how CEOs can raise the performance of a system by being more driven. Instead, you speak of structures, research and franchising models. What were you trying to accomplish?

SS: One thing that we know about human nature is that we engage in something that psychologists call the fundamental attribution error. Humans almost always over-attribute performance to personal factors. If we evaluate what makes a business successful, we overweigh personality, like how driven is the CEO, how good are their people skills, or how do people relate to them. We underestimate the importance of structural factors. For example, does the business have the right strategy? Does the business model work in the industry?

The idea behind my book is to take what academics have found as research about franchising and say when it is a good idea to franchise a business and when it isn't. If you're going to franchise a business, what pieces of the strategy should you put together to make it effective based on what we know about the economics of designing an effective franchising for this model. 

When does the economics of a particular business lend itself to having a master franchise and when does it not? What does the research show to support that argument? What are good industries for franchising? What's the right mix between the number of franchise and company-owned outlets? Which outlets should you franchise and which should your company own? All of those are things that we have a set of explanations for based on the economics underlying the businesses and where we can say, "Look, here is what the research shows to do if these circumstances are present in your business."

BMM: You sort of say that franchisors leave money on the table by not having the right structure. One example you use of poor structure is when franchisors only have franchised stores. Yet I can think of some large, mature franchisors that only have franchised stores: Quiznos, Dunkin' Donuts, Cold Stone Creamery, NexCen Brands and The UPS Store/Mail Boxes Etc. immediately come to mind. Are you saying that these firms are not all they could be?

SS: Franchisors need to separate out the difference between what's the right strategy for a mature system and what's the right strategy when a system is growing. One needs to have company-owned outlets more in the early years than one does when a system gets more mature because you need to figure things out. [In the early years] the franchisor may not have figured out exactly the right product mix to have, or the right operating procedures for the business. If a franchisor doesn't have any company-owned stores, it may be very difficult for them to figure that out in the early years.

When talking about big mature systems, it may be that the system isn't changing products very often. Franchisors have already figured out the operations. They don't need company-owned outlets to as much of an extent. But I will say that it's hard to see how in the really long run, if there's going to be any kind of new product introduction and any kind of innovation in the system, that a franchisor can have a purely franchised system and be competitive in the long run. Because it's going to be much harder for the company to get needed information to figure out what are the right new products, for example, that would need to be introduced. If all that information is coming just through franchisees, franchisors are never going to get anything but filtered information.

BMM: I would think that a consultant should be able to persuade a franchising firm like NexCen Brands [holding company to franchisors MaggieMoo's, Great American Cookies, Marble Slab Creamery, The Athlete's Foot and others] that the company is less stable by leaving on the table, say, $12 million in profits this year because they aren't structured to their optimal mix of company-owned to franchised stores. Don't you?

SS: It's more difficult than that, in fact, because a consultant can't categorically say that the firm is giving up $12 million. What they are stating in essence is, "You're giving up the opportunity to be in place to figure out the next generation of products that might really appeal to your customers." They're going to reply, "No, we think we're fine on knowing this." There's no way to prove otherwise. It's just that if we look at [industry] patterns, completely franchised chains are much worse on average at developing new products over long periods of time. That suggests that they are missing out by not having company-owned outlets.

I suspect that in the long run most of the purely franchised systems are missing a competitive edge. They're probably missing opportunities to get information that they need to innovate. They're probably lacking insights that would help them be more successful that operating company-owned outlets would provide.

One of the most difficult things—whether it's academics doing research, consultants giving advice, or managers trying to convince more senior managers—is how to tell somebody that they would have made more money if only they had done something they didn't do.

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